Will the banks go bust in a property slump?
IN the 1930s, the bank robber "Slick" Willie Sutton was once asked why he robbed banks. Sutton simply replied, "because that's where the money is".
What I love about his response is that he so completely missed the point of the question.
Still, what he said remains true today. Banks and other lenders in Ireland have raked it over the past decade. But with the housing market now stumbling, spare a thought for the bankers and those who own bank stocks.
As mortgage lending has stalled over recent months, bank stocks have slumped-down nearly 20 per cent from their highs in February. This makes them the worst performing bank stocks in Europe this year. Did someone say "Takeover"?
Beyond the folks in pin-stripped suits though, the effects of the housing downturn on banks raise wider concerns. Bank lending is a key channel though which a property crash could turn into a broader economic crash. When losses from property lending begin to mount, banks may become weary of lending funds to the other sectors of the economy. If companies are unable to borrow, investment spending dries up and the economy heads south. In the worst cases, banks themselves can go bankrupt.
Of course, Ireland's housing market at the moment is not crashing -- it is correcting gradually downward. That is good news.
The second piece of good news is that in the experiences of other rich countries, housing busts rarely lead to serious problems for banks. Even in the famous UK housing crash in the early 1990s, the major banks and building societies withstood the test fairly well.
In the face of rising interest rates, hard-pressed homeowners made every effort to stay current on mortgage repayments by cutting back on other spending. Even at their peak, the rate at which lenders foreclosed on delinquent borrowers remained below one per cent per year.
What's more, the banks were able to make substantial recoveries from re-selling repossessed properties.
The exception is the Scandinavian countries in the early 1990s. In Finland and Sweden, house prices roughly doubled during the second half of the 1980s. Booms turned into busts in the early 1990s as interest rates rose, oil prices soared, and the USSR -- Finland's largest export market -- collapsed.
The property bust, continuing high interest rates and deterioration of the economy progressively weakened the banks in both countries. By early 1993, all the banks in Finland and two of the largest four banks in Sweden had gone belly-up and had to be taken over by the government.
Why did things go so terribly wrong? The short answer is that the banks didn't do what good banks are supposed to do. They didn't comprehensively evaluate the customers that were asking for loans, or the projects they were being asked to bankroll. Instead, the banks relied too heavily on collateral rather than on the viability of the projects themselves.
They made other fatal mistakes too. In the early 1980s, there were only a few banks in each country. But new banks sprung up and entered the market when in 1980 banking rules were relaxed.
As competition intensified in the 1980s, banks fought for market share by entering into new business areas and by taking on new risks.
The problem for someone entering into a new business area is that is easy to get scammed by people who already know those areas well. And that's exactly what happened to the Nordic banks.
For example, Swedish banks lent heavily to anyone with blonde hair wanting to buy property in Belgium. This of course raises the question as to why anyone would wish to own property in Belgium, but let's not wrestle with that one.
Today in Brussels when the natives recall the 1980s, they talk about there having been three prices for property: the price for locals, the price for foreigners, and the price for Swedes. One wonders if the eastern Europeans are saying something similar currently about the Irish.
Another big mistake is that the Scandinavian banks put too many of their eggs in one basket. Almost without them realising it, the risks that the banks took became highly concentrated. Finnish and Swedish banks became overly exposed to individual companies and sectors, especially property.
The most important point, however, is that the banking crises in Scandinavia were more directly linked to drops in the value of commercial property rather than to the decline in house prices. A struggling homeowner that hands back the keys of the house causes a mild sting to a bank; a property developer that folds owing the bank a packet inflicts a terrible pain.
Investors in shares of Irish banks are assuming that Irish banks have leaned the bitter lessons from their Scandinavian counterparts. Let's hope they are right.
Dr Alan Ahearne is a former senior economist at the Federal Reserve Board in Washington DC. He currently lectures in economics at Cairnes School of Business and Public Policy at NUI Galway
- DR ALAN AHEARNE
